Bond Ladders And Income Annuities: Simple Is Beautiful

I spent some time on Google, but could not ascertain the origins of the term fixed income. Presumably, it was created to describe investments where cash flows are dictated via a contractual obligation. A simple example is a government bond that pays fixed coupons and returns the principal at maturity. However, the term "fixed income" has now come to describe pretty much any investment obligated to pay a prespecified stream of cash flows – some of which are more complex (e.g., mortgage-backed securities).

Brushing some details under the rug (e.g., some bonds can be called), fixed income investments effectively allow investors to purchase future cash flows with a high degree of certainty 1. However, it is important to note this degree of certainty only applies when the investments are held to maturity.

If an investment is sold before it matures, the sales proceeds will naturally be at the mercy of the market and subject to reinvestment risk and frictional costs. Thus, in the case where fixed-income investments are not held to maturity, cash flow certainty and timing are gone and complexity increases.

As a reminder, the beauty of fixed income in its simplest, non-financially-engineered form, is a known cash payment with known timing2

Of course, advocates of financial engineering can make reasonable arguments that one can synthetically create more optimal portfolios and replicate the benefits of fixed income cash flows. And while that might be true, in theory and setting aside tax and frictional cost considerations, when an advisor is servicing a client who is not a financial expert, the simplicity of financial instruments that deliver known cash flows at known times is tough to beat.

In this piece, I restore the "sanctity" of fixed income and highlight why easy-to-understand financial instruments with known cash flows and known timing are potentially beneficial for clients. In particular, I advocate for the design and utilization of fixed cash flows in the context of asset-liability management (ALM) – thereby mitigating, if not avoiding, market volatility. While relevant to other investment mandates (e.g., private foundations with cash flow liabilities), I discuss this notion in the context of retirement income.

I will discuss bond ladders and income annuities. In addition to potential cost and tax savings, the math behind these approaches (i.e., time value of money) is much simpler than many of the statistical models used for portfolio management. Accordingly, I believe this approach can facilitate greater understanding and peace of mind for many investors. Retirement income is one natural application for this strategy. However, it can also be helpful in estate planning for blended families and other situations where one wishes to manage multiple beneficiaries’ claims to income and principal.

Note: Readers interested in this topic may also like to read an earlier article I wrote (Destroying Stable Income Streams) that focuses on a similar topic, but primarily in the context of dividends.

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index.


Note: This article focuses on the context of retirement income, but it is worth noting the ideas are also relevant to other investment applications where one is tasked with addressing liabilities in the form of future outgoing cash flows (e.g., pensions, endowments, private foundations, etc.).

When it comes to investment strategies for retirement (and almost any other application), most individual and professional practitioners have adopted an approach based on total return investing and modern portfolio theory (MPT). So the natural income from the portfolio (e.g., dividends and interest) is typically reinvested and income required for spending is chiseled off from the portfolio as needed.

Portfolio volatility presents a risk as it can jeopardize one’s financial security in retirement by increasing the probability of running out of money (i.e., potentially less money to chisel from). For example, retirees may still need to withdraw from their portfolios during market declines and this would result in forced selling at depressed prices. Of course, conservative financial planning should allow for such situations and be able to withstand such scenarios.

This typically results in constructing a diversified portfolio that will offer an attractive balance of growth potential and risk. If we confine ourselves to a world with just stocks and bonds (for the sake of simplicity), then the idea would be for stocks to generate sufficient long term growth to help combat inflation or generate real returns 3 while bonds might be regarded as a diversifying asset. As long as the bond allocation keeps up with inflation and tends to zig when stocks zag, many investors are content to maintain significant bond allocations in order to balance risk in their portfolios.

Side note: Why do bonds typically exhibit lower returns and less volatility than stocks?
On the one hand, stocks are effectively perpetual securities, and their dividends are not guaranteed. On the other hand, bonds ultimately mature and offer contractually guaranteed cash flows. Put simply, bonds offer more certainty than stocks. Thus, it is unsurprising stock prices tend to be more volatile than bond prices, and investors label bonds as the safer investment.

Investment theory indicates higher returns are the reward for higher risks – assuming that risk is systemic and cannot be diversified away. In the US, this has certainly been the case historically with stocks handily outperforming bonds over the long run. So conventional wisdom holds that stocks should have higher expected returns than bonds over longer periods since they are more volatile.

This risk-based argument is presented from the investor’s perspective. What is less discussed is the flipside: the issuer perspective. That is, what about the perspective of the corporate or government issuers of securities? Let us take a corporation seeking to raise capital as an example. From their vantage point, issuing equity can be attractive in the sense that it does not impose any contractual payments (dividends, if any, can be skipped). However, if they issue a bond, then they will be obligated to make interest payments and repay the principal at maturity. In this light, issuing equity imposes less financial constraint and may be viewed as a favorable option. Accordingly, they may be encouraged to issue equity rather than bonds. In turn, this could tip the scales of supply in demand in such a way to make stocks cheaper and more conducive to higher returns.

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  • This document is provided for informational purposes only.
  • I am not endorsing or recommending the purchase or sales of any security.
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